There's Deep Fraud On Wall Street, And Goldman's Behavior In Greece Is Just The Tip

Mr. President, last Thursday, the bankruptcy examiner for Lehman
Brothers Holdings Inc. released a 2,200 page report about the
demise of the firm which included riveting detail on the firm’s
accounting practices. That report has put in sharp relief
what many of us have expected all along: that fraud and
potential criminal conduct were at the heart of the financial
crisis. Now that we’re beginning to learn many of the
facts, at least with respect to the activities at Lehman
Brothers, the country has every right to be outraged.
Lehman was cooking its books, hiding $50 billion in toxic assets
by temporarily shifting them off its balance sheet in time to
produce rosier quarter-end reports. According to the bankruptcy
examiner's report, Lehman Brothers’ financial statements were
"materially misleading" and its executives had engaged in
"actionable balance sheet manipulation." Only further
investigation will determine whether the individuals involved can
be indicted and convicted of criminal wrongdoing.

According to the examiner’s report, Lehman used accounting tricks
to hide billions in debt from its investors and the public.
Starting in 2001, that firm began abusing financial transactions
called repurchase agreements, or “repos.” Repos are
basically short-term loans that exchange collateral for cash in
trades that may be unwound as soon as the next day. While
investment banks have come to over-rely upon repos to finance
their operations, they are neither illegal nor questionable;
assuming, of course, they are clearly accounted for.

Lehman structured its repo agreements so that the collateral was
worth 105 percent of the cash it received – hence, the name “Repo
105.” As explained by the New York Times' DealBook, “That
meant that for a few days – and by the fourth quarter of 2007
that meant end-of-quarter – Lehman could shuffle off tens of
billions of dollars in assets to appear more financially healthy
than it really was.”

Even worse, Lehman’s management trumpeted how the firm was
decreasing its leverage so that investors would not flee from the
firm. But inside Lehman, according to the report, someone
described the Repo 105 transactions as “window dressing,” a nice
way of saying they were designed to mislead the public.

Ernst & Young, Lehman's outside auditor, apparently became
“comfortable” with, and never objected to, the Repo 105
transactions. And while Lehman never could find a U.S. law
firm to provide an opinion that treating the Repo 105s as a sale
for accounting purposes was legal, the British law firm
Linklaters provided an opinion letter under British law that they
were sales and not mere financing arrangements. And so
Lehman ran the transactions through its London subsidiary and
used several different foreign bank counterparties.

Mr. President, the SEC and Justice Department should pursue a
thorough investigation, both civil and criminal, to identify
every last person who had knowledge that Lehman was misleading
the public about its troubled balance sheet – and that means
everyone from the Lehman executives, to its board of directors,
to its accounting firm, Ernst & Young. Moreover, if the
foreign bank counterparties who purchased the now infamous "Repo
105s" were complicit in the scheme, they should be held
accountable as well.

Returning the Rule of Law to Wall Street

Mr. President, it is high time that we return the rule of law to
Wall Street, which has been seriously eroded by the deregulatory
mindset that captured our regulatory agencies over the past 30
years, a process I described at length in my speech on the floor
last Thursday. We became enamored of the view that
self-regulation was adequate, that “rational” self-interest would
motivate counterparties to undertake stronger and better forms of
due diligence than any regulator could perform, and that market
fundamentalism would lead to the best outcomes for the most
people. Transparency and vigorous oversight by
outside accountants were supposed to keep our financial system
credible and sound.

The allure of deregulation, instead, led to the biggest financial
crisis since 1929. And now we’re learning, not
surprisingly, that fraud and lawlessness were key ingredients in
the collapse as well. Since the fall of 2008, Congress, the
Federal Reserve and the American taxpayer have had to step into
the breach – at a direct cost of more than $2.5 trillion –
because, as so many experts have said: "We had to save the
system."

But what exactly did we save?

First, a system of overwhelming and concentrated financial power
that has become dangerous. It caused the crisis of 2008-2009 and
threatens to cause another major crisis if we do not enact
fundamental reforms. Only six U.S. banks control assets
equal to 63 percent of the nation’s gross domestic product, while
oversight is splintered among various regulators who are often
overmatched in assessing weaknesses at these firms.

Second, a system in which the rule of law has broken yet
again. Big banks can get away with extraordinarily bad
behavior – conduct that would not be tolerated in the rest of
society, such as the blatant gimmicks used by Lehman, despite the
massive cost to the rest of us.

The Lessons of Lehman Brothers and Other Examples

Mr. President, what lessons should we take from the bankruptcy
examiner’s report on Lehman, and from other recent examples of
misleading conduct on Wall Street? I see three.

First, we must undo the damage done by decades of
deregulation. That damage includes financial institutions
that are “too big to manage and too big to regulate” (as former
FDIC Chairman Bill Isaac has called them), a “wild west” attitude
on Wall Street, and colossal failures by accountants and lawyers
who misunderstand or disregard their role as gatekeepers.
The rule of law depends in part on manageably-sized institutions,
participants interested in following the law, and gatekeepers
motivated by more than a paycheck from their clients.

Second, we must concentrate law enforcement and regulatory
resources on restoring the rule of law to Wall Street. We
must treat financial crimes with the same gravity as other
crimes, because the price of inaction and a failure to deter
future misconduct is enormous.

Third, we must help regulators and other gatekeepers not only by
demanding transparency but also by providing clear, enforceable
“rules of the road” wherever possible. That includes
studying conduct that may not be illegal now, but that we should
nonetheless consider banning or curtailing because it provides
too ready a cover for financial wrongdoing.

The bottom line is that we need financial regulatory reform that
is tough, far-reaching, and untainted by discredited claims about
the efficacy of self-regulation.

The Fraud Enforcement and Recovery Act

When Senators Leahy, Grassley and I introduced the Fraud
Enforcement and Recovery Act (FERA) last year, our central
objective was restoring the rule of law to Wall Street. We
wanted to make certain that the Department of Justice and other
law enforcement authorities had the resources necessary to
investigate and prosecute precisely the sort of fraudulent
behavior allegedly engaged in by Lehman Brothers.

We all understood that to restore the public's faith in our
financial markets and the rule of law, we must identify,
prosecute, and send to prison the participants in those markets
who broke the law. Their fraudulent conduct has severely damaged
our economy, caused devastating and sustained harm to countless
hard-working Americans, and contributed to the widespread view
that Wall Street does not play by the same rules as Main Street.

FERA, signed into law in May, ensures that additional tools and
resources will be provided to those charged with enforcement of
our nation's laws against financial fraud. Since its
passage, progress has been made, including the President’s
creation of an interagency Financial Fraud Enforcement Task
Force, but much more needs to be done.

Many have said we should not seek to "punish" anyone, as all of
Wall Street was in a delirium of profit-making and almost no one
foresaw the sub-prime crisis caused by the dramatic decline in
housing values. But this is not about retribution.
This is about addressing the continuum of behavior that took
place – some of it fraudulent and illegal -- and in the process
addressing what Wall Street and the legal and regulatory system
underlying its behavior have become.

As part of that effort, we must ensure that the legal system
tackles financial crimes with the same gravity as other crimes.
When crimes happened in the past (as in the case of Enron, when
aided and abetted by, among others, Merrill Lynch, and not
prevented by the supposed gatekeepers at Arthur Andersen), there
were criminal convictions. If individuals and entities
broke the law in the lead up to the 2008 financial crisis (such
as at Lehman Brothers, which allegedly deceived everyone,
including the New York Fed and the SEC), there should be civil
and criminal cases that hold them accountable.

If we uncover bad behavior that was nonetheless lawful, or that
we cannot prove to be unlawful (as may be exemplified by the
recent reports of actions by Goldman Sachs with respect to the
debt of Greece), then we should review our legal rules in the US
and perhaps change them so that certain misleading behavior
cannot go unpunished again. This will not be easy. As
the Wall Street Journal’s “Heard on the Street” noted last week,
“Give Wall Street a rule and it will find a loophole.”

Systemic issues in Uncovering and Prosecuting FraudThis confirms
what I heard On December 9 of last year, when I convened an
oversight hearing on FERA. As that hearing made clear,
unraveling sophisticated financial fraud is an enormously
complicated and resource-intensive undertaking, because of the
nature of both the conduct and the perpetrators.

Rob Khuzami, head of the SEC’s enforcement division, put it this
way during the hearing:

“White-collar area cases, I think, are distinguishable from
terrorism or drug crimes, for the primary reason that, often,
people are plotting their defense at the same time they're
committing their crime. They are smart people who understand that
they are crossing the line, and so they are papering the record
or having veiled or coded conversations that make it difficult to
establish a wrongdoing.”

In other words, Wall Street criminals not only possess enormous
resources but also are sophisticated enough to cover their tracks
as they go along, often with the help, perhaps unwitting, of
their lawyers and accountants.

Assistant Attorney General Lanny Breuer and Khuzami, along with
Assistant FBI Director Kevin Perkins, all emphasized at the
hearing the difficulty of proving these cases from the historical
record alone. The strongest cases come with the help of
insiders, those who have first-hand knowledge of not only conduct
but also motive and intent. That’s why I’ve applauded the
efforts of the SEC and DOJ to use both carrots and sticks to
encourage those with knowledge to come forward.

At the conclusion of that hearing in December, I was confident
that our law enforcement agencies were intensely focused on
bringing to justice those wrongdoers who brought our economy to
the brink of collapse.

Going forward, we need to make sure that those agencies have the
resources and tools they need to complete the job. But we
are fooling ourselves if we believe that our law enforcement
efforts, no matter how vigorous or well funded, are enough by
themselves to prevent the types of destructive behavior
perpetrated by today’s too-big, too-powerful financial
institutions on Wall Street.

Is Lehman Brothers an Isolated Example?

Mr. President, I’m concerned that the revelations about Lehman
Brothers are just the tip of the iceberg. We have no reason
to believe that the conduct detailed last week is somehow
isolated or unique. Indeed, this sort of behavior is hardly
novel. Enron engaged in similar deceit with some of its
assets. And while we don’t have the benefit of an
examiner’s report for other firms with a business model like
Lehman’s, law enforcement authorities should be well on their way
in conducting investigations of whether others used similar
“accounting gimmicks” to hide dangerous risk from investors and
the public.

The Case of Greece

At the same time, there are reports that raise questions about
whether Goldman Sachs and other firms may have failed to disclose
material information about swaps with Greece that allowed the
country to effectively mask the full extent of its debt just as
it was joining the European Monetary Union (EMU). We
simply do not know whether fraud was involved, but these actions
have kicked off a continent-wide controversy, with ramifications
for U.S. investors as well.

In Greece, the main transactions in question were called
cross-currency swaps that exchange cash flows denominated in one
currency for cash flows denominated in another. In Greece’s
case, these swaps were priced “off-market,” meaning that they
didn’t use prevailing market exchange rates. Instead, these
highly unorthodox transactions provided Greece with a large
upfront payment (and an apparent reduction in debt), which they
then paid off through periodic interest payments and finally a
large “balloon” payment at the contract’s maturity. In
other words, Goldman Sachs allegedly provided Greece with a loan
by another name.

The story, however, does not end there. Following these
transactions, Goldman Sachs and other investment banks underwrote
billions of Euros in bonds for Greece. The questions being
raised include whether some of these bond offering documents
disclosed the true nature of these swaps to investors, and, if
not, whether the failure to do so was material.

These bonds were issued under Greek law, and there is nothing
necessarily illegal about not disclosing this information to bond
investors in Europe. At least some of these bonds, however,
were likely sold to American investors, so they may therefore
still be subject to applicable U.S. securities law. While
“qualified institutional buyers” (QIBs) in the U.S. are able to
purchase bonds (like the ones issued by Greece) and other
securities not registered with the SEC under Securities Act of
1933, the sale of these bonds would still be governed by other
requirements of U.S. law. Specifically, they presumably
would be subject to the prohibition against the sale of
securities to U.S. investors while deliberately withholding
material adverse information.

The point may be not so much what happened in Greece, but yet
again the broader point that financial transactions must be
transparent to the investing public and verified as such by
outside auditors. AIG fell in large part due to its credit
default swap exposure, but no one knew until it was too late how
much risk AIG had taken upon itself. Why do some on Wall
Street resist transparency so? Lehman shows the
answer: everyone will flee a listing ship, so the less
investors know, the better off are the firms which find
themselves in a downward spiral. At least until the final
reckoning.

Who’s Responsible? The Role of Congress, Regulators,
Accountants and Lawyers

Who’s to blame for this state of affairs, where major Wall Street
firms conclude that hiding the truth is okay? Well, there’s
plenty of blame to go around. As I said previously, both
Congress and the regulators came to believe that self-interest
was regulation enough. In the now-immortal words of Alan
Greenspan, “Those of us who have looked to the self-interest of
lending institutions to protect shareholder's equity -- myself
especially -- are in a state of shocked disbelief.” The
time has come to get over the shock and get on with the
work.

What about the professions? Accountants and lawyers are
supposed to help insure that their clients obey the law.
Indeed, they often claim that simply by giving good advice to
their clients, they’re responsible for far more compliance with
the law than are government investigators. That claim rings
hollow, however, when these professionals now seem too often
focused on helping their clients get around the law.

Experts like Professor Peter Henning of Wayne State University
Law School, looking at the Lehman examiner’s report on the Repo
105 transactions, are stunned that the accountant Ernst &
Young never seemed to be troubled in the least about it. Of
course, the fact that a Lehman executive was blowing a whistle on
the practice in May 2008 did not change anything, other than to
cause some discomfort in the ranks. While saying he was
confident he could clear up the whistleblower’s concerns, the
lead partner for Lehman at Ernst & Young wrote that the
letter and off-balance sheet accounting issues were "adding
stress to everyone."

As Professor Henning notes, one of the supposed major effects of
the Sarbanes-Oxley Act was to empower the accountants to
challenge management and ensure that transactions were accounted
for properly. Indeed, it was my predecessor,
then-Senator Biden, who was the lead author of the provision
requiring the CEO and CFO to attest to the accuracy of financial
statements, under penalty of criminal sanction if they knowingly
or willfully certified materially false statements. I don't
believe this is a failure of Sarbanes-Oxley. A law is not a
failure simply because some people subsequently violate it.

I am deeply disturbed at the apparent failure of some in the
accounting profession to change their ways and truly undertake
the profession's role as the first line of defense (the
gatekeeper) against accounting fraud. In just a few years
time since the Enron-related death of the accounting firm Arthur
Andersen, one might have hoped that "technically correct" was no
longer a defensible standard if the cumulative impression left by
the action is grossly misleading. But apparently that
standard as a singular defense is creeping back into the
profession.

The accountants and lawyers weren't the only gatekeepers. If
Lehman was hiding balance sheet risks from investors, it was also
hiding them from rating agencies and regulators, thereby allowing
it to delay possible ratings downgrades that would increase its
capital requirements. The Repo 105 transactions allowed Lehman to
lower its reported net leverage ratio from 17.3 to 15.4 for the
first quarter of 2008, according to the examiner's report. It was
bad enough that the SEC focused on a misguided metric like net
leverage when Lehman's gross leverage ratio was much higher and
more indicative of its risks. The SEC's failure to uncover such
aggressive and possibly fraudulent accounting, as was employed on
the Repo 105 transactions, provides a clear indication of the
lack of rigor of its supervision of Lehman and other investment
banks.

The SEC in years past allowed the investment banks to increase
their leverage ratios by permitting them to determine their own
risk level. When that approach was taken, it should have
been coupled with absolute transparency on the level of
risk. What the Lehman example shows is that increased
leverage without the accountants and regulators and credit rating
agencies insisting on transparency is yet another recipe for
disaster.

Conclusion

Mr. President, last week’s revelations about Lehman Brothers
reinforce what I’ve been saying for some time. The folly of
radical deregulation has given us financial institutions that are
too big to fail, too big to manage, and too big to
regulate. If we have any hope of returning the rule of law
to Wall Street, we need regulatory reform that addresses this
central reality.

As I said more than a year ago: "At the end of the day,
this is a test of whether we have one justice system in this
country or two. If we don’t treat a Wall Street firm that
defrauded investors of millions of dollars the same way we treat
someone who stole 500 dollars from a cash register, then how can
we expect our citizens to have faith in the rule of law?
For our economy to work for all Americans, investors must have
confidence in the honest and open functioning of our financial
markets. Our markets can only flourish when Americans again trust
that they are fair, transparent, and accountable to the laws."